A leverage-based explanation of the ESG premium: evidence from China

Investing according to Environmental, Social, and Governance (ESG) criteria has received widespread attention globally, but empirical research on whether ESG investing can generate excess returns has yielded inconsistent results. Our study attempts to reconcile the conflicting results of research on the ESG premium and provides guidance for ESG investors. Using ESG score data from Chinese A-share listed companies, our research reveals a positive correlation between expected returns and ESG scores in highly leveraged firms, but a negative association in low-leverage firms. This premium cannot be explained by common risk factors and is robust to controlling for common financial indicators. We argue that this phenomenon is related to green finance policies and financial leverage. These policies have mitigated the externalities associated with ESG-related risks. However, the impact of low-interest loan policies on companies is heterogeneous, with high-leverage companies deriving greater advantage, possibly because, for highly leveraged non-financial firms, financing costs account for a larger proportion of total costs, making the reduction in loan interest rates more significant in affecting the company’s overall expenses.